Apr 24, 2012

Commodity prices and trade policy challenges - Part I

Source: World Bank


The above is a plot from the world bank data that I downloaded in excel format from here (click on the small link to historical data under prices section).  It's a data mine for world commodity price movement analysis. I have plotted the commodity price indices from 1960 to March 2012 on a monthly basis. The data is price adjusted by taking a base of 100 for US dollar for the year 2005. Non energy includes agriculture, food, fertilizers and other raw materials. 
The recent years has seen a big price movement upwards, except for the global slumps. It is true for all three heads under commodities. The trend is clearly visible from 2000 onward.  Experts have reasoned about the causes and I am summarizing from many research papers below:

  • High and sustained economic growth combined with expansionary macroeconomic policies. 
  • Derived from the point above, increased demand from fast growing developing countries such as BRIC, primarily China. This is especially true for energy, metals and minerals. 
  • Low capital investment esp in non-energy commodities for past three decades due to lack of returns on investment. If one sees the past thirty years, the price increase was not lucrative enough to invest. 
  • Geopolitical issues such as Iran that effects Energy prices.
  • Financial institutions and their derivative instruments. They have entered in a big way into this market. 
Some other interesting points are:
  • Energy prices and food prices are correlated. It is argued that agriculture being an energy intensive industry gets affected by energy price movements. It is estimated that, globally, agriculture is 4 to 5 times more energy intensive than manufacturing!
  • Bio-fuels, contrary to popular perception, are not a cause. Multiple research studies have shown that their effect has been mostly negligible in the current price rise. However, if the trend continues to divert food to fuels, it might start having an effect. 
  • The research studies on speculation in commodities market are inconclusive. The probability of such activities affecting long term trends is quite low, but in the short term, they may induce higher price variability by inducing additional volatility. However, the current rally is a sustained one and therefore difficult to attribute to speculative activities. 
In this blog, I will take up the Non-energy index discussions, which relates mostly to agricultural products. First I will talk about supply side:
  1. The supply side in this area, globally, is concentrated in few players. Each agriculture commodity is concentrated in the hands of four or five major players and a few small players. The export policies of these countries affects the commodity prices in a significant manner. And when it comes to sensitive commodities countries resort to export bans and prohibitive taxes as a response to global price movements. 
  2. The supply side in agriculture also suffers from lack of capital investment and destruction of supply due to wrong policies. UNCTAD report (see page 11), points at the following reasons:
    • Agricultural production has suffered from chronic under-investment for several decades in many areas of the world. This is due in part to the low commodity prices of the 1980s and 1990s that discouraged investment. 
    • In addition, agricultural production in many developing countries was disrupted by government neglect and under-investment, often in response to policies imposed by international financial institutions that dismantled State support to the agricultural sector. 
    • Further damage was wrought by the heavily distorted nature of the international trading system that required many developing countries to open their markets, while continuing to allow developed countries to depress their agricultural prices through massive subsidies. The outcome of this neglect and under-investment has been a lagging supply response and an increased vulnerability of production, notably to the effects of climate change.
  3. In recent years, there has been some shocks on supply due to drought in Australia, weather related low yield in Canada, fire in Russia, and so on. This has further put pressure. 
The demand side issues are pointed out in the commodity price rise factors. They apply to agricultural and raw materials too. 

Now comes the policy issues. There are countries like ours, where Sugar, Cotton, Onions and such products are very sensitive issues. There are multiple interested parties. How should a policymaker strike a balance. Most of such commodities have an export ban, which is relaxed at times, when the prices fall domestically and the international prices remain high. The farmers and growers would like to gain from  international prices rally. Food security issues dictate otherwise. Also, there is a conflict among users and producers of raw materials. E.g. textile mill owners would like to have cotton cheap by banning exports and so on. As the commodity prices were almost stagnant for decades, the issue was dormant. Now that the commodities are on rise, big time, the pressure is going to rise in coming years. Balancing the interests would be challenging for the policy makers. I would talk about this issue in part 2 of this post.